SILVERAXIS - TODAY IN SILVER

I could be wrong but I am getting the sense from the latest Federal Reserve statistical releases that we are now seeing some unsticking in the financial system. It is subtle and too early to represent a trend but it is the first sign in several months. Combined with a decline in the silver basis in the past few days to match the decline in the gold basis over the past two months, we could be on the edge of a monetary slippery slope that takes everyone by surprise (think opposite of deflation, even if just in the short term). Indeed, the basis in silver fell almost to zero earlier this week and remains on the verge of backwardation. Is this just anticipation of the G-20 “Global Meltdown” Summit to take place this weekend or something else?  There’s a bit less than 72 hours to contemplate the possibilities. Personally speaking, I’ll be doing more than just contemplating — I’ll be looking at some December 2008 COMEX call options in silver and gold.

First, apologies for not posting the past couple of weeks, it will pick up shortly. Second, I really appreciate all the comments (okay, not the silly ones that bemoan my absence) and hope that you will keep it up. I would particularly appreciate seeing some of the “regulars” linking to and discussing the major stories of the day as I know these discussions you’ve been having in the comment section are being read and enjoyed by a lot of people.

As far as the silver and gold market, what can I say? Another week and more of the same. The monetary base continues to explode and silver and gold continue to struggle near their lows.

Despite the obituaries that have been written about silver lately, the white monetary metal is alive and well, as am I. The rumors were well founded, however, considering my temporary disappearance and silver’s plunge to a low of $8.40 basis the December 2008 COMEX futures earlier in the week. The swoon in silver occurred as gold carried out a somewhat unconvincing recovery from its own low of $681.00 on Friday the 24th. Currently, gold remains below the important $730 range and needs to move up quickly or else gravity will drag it and silver back down again.

I must say that it was somewhat liberating to not post any comments or answer emails for a few days but now I’m back on the job. I was prepared to write had something extraordinary taken place but the past week didn’t offer much in the way of critical material with perhaps the only exception being that the Federal Reserve has once again proven me correct: the new Commercial Paper Funding Facility (CPFF) is turning out to be the primary mechanism of Bernanke’s helicopter operation as the latest Factors Affecting Reserve Balances H.4.1 Report shows. According to this report, Reserve Balances of banks grew a mind-boggling $200 billion in the latest week to $425 billion as the Federal Reserve acquired $145 billion of commercial paper. If this increase is not somehow neutralized by the Fed during the coming weeks, it will show up in the Monetary Base.

I believe the critical point for gold and silver will come if and when the banks begin to lend against these massive new reserves. Assuming I’m right about the consequences, we could see an initial move by gold to the $1,000 level and silver to $16 or so in the matter of a few days as the insiders position themselves. Alternatively, as long as the deflation theme continues to threaten the world order with the prospects of imminent financial collapse, gold and silver will remain depressed.

It would be a very bad thing if gold and silver should take out the lows of the last 2 weeks as that points to a near-term economic collapse of epic proportions. The best analogy I can think of is an empty bottle being held under water–the longer and deeper it is held, the more explosive the eventual rise, but if the bottle is pushed too deep, the extreme water pressure will cause the bottle to burst.

Today we got news that the U.S. monetary base consisting of bank reserves and currency in circulation has skyrocketed to $1.15 trillion from $850 billion a mere 6 weeks ago, which is an increase of 35%, or 300% annualized. Meanwhile, the Adjusted Monetary Base tracked by the St. Louis Fed (which calculates the monetary base using bi-weekly averages) clocked in at $1.19 trillion. Here is how it looks on a chart:

Click Chart to Enlarge

The Fed has added as much to the monetary base in 6 weeks as it has added in any prior 10 year period going back to the early 1980s. Indeed, the rate of increase appears to be about $100 billion every two weeks and yet the logjam in the credit markets still has not been cleared.

So, is this the fabled helicopter drop? Yessirreee! There is, however, a slight matter that deserves some mention. The money dropped from the helicopter has not reached the ground yet. In other words, most of this money is still being held by the banks in the form of Reserve Balances. Put another way, it has not yet started to work its way down through the fractional-reserve lending process to the credit-strapped private sector.

The reason these funds are being held and not loaned out by the banks is simple. The Fed is actually paying banks to hold the funds in reserves. Indeed, the Fed has just today increasing the rate it is paying by 40 basis points. Some of you may know that the Fed was originally going to start paying banks for excess Reserve Balances starting in 2011 but the recent emergency bailout legislation moved that date up so that Reserve Balances would start to earn interest immediately. The Fed’s intent is to try to keep the massive increases in Reserve Balances close to the heart so that these funds serve mainly to shore up the banks’ balance sheets but don’t create a tsunami of “unnecessary liquidity” in the money supply. Remember what I said earlier about jumping out of a burning building. In helicopter lingo, the $300 billion has been dropped but it is fluttering in midair due to an updraft created by the rotor.

I suspect, however, that the Fed will have to dispense with its “gradualism” before too long and fly the helicopter to open airspace in order to avoid a crash. Even if the Fed has no intention of moving clear, the longer the money stays out there fluttering in midair, the more difficult it will be to keep it aloft. Moreover, once the dropped money has cleared the updraft from the helicopter’s rotor, it can no longer be reclaimed by the Fed without consequences, especially while the global economy remains on an unsure footing. Thus I suspect most of the dropped money will eventually flutter to the ground.

What I think we should watch for in particular is an increase in M1, which includes circulating currency (Federal Reserve Notes) and demand deposits. The latest data only goes up to October 13, but that data actually shows weekly average M1 shrinking by as much as $100 billion since the end of September. If and when we see M1 reverse sharply upwards, we could start to suspect that the first batches of the monetary drop are starting to reach the ground and that a “hyperinflationary event” will not be very far behind. How long could this take? I give it 6 to 18 months although others say it could be literally weeks from now. Jim Sinclair claims something big will happen in 13 to 88 days, which is the timeframe between the U.S. elections and the inauguration of the next President.

Below you will find one simplistic method to check spreads in various commodities and even in gold and silver, assuming you can use graphic programs to manipulate images. Normally I would reveal methodologies such as this only to paid GSUL members and Founding Members of The Metal Augmentor, but I’m hoping some of you will appreciate my sharing this by helping create similar charts for other commodities. If there is interest from enough of you to create more of these charts, please leave comments and I will walk you through how to do it as well as split up the commodities between the “volunteers”.

Note that in the case of Crude Oil, I was able to find a historical instance of 56% annualized contango in the spread between the December 2001 and March 2002 futures that existed during the summer of 2001. I’m not sure this is the highest level that was reached but it seems extreme enough for our purposes. Currently, the contango between the December and March futures is about 8% annualized. Although this is small compared to the summer of 2001, please keep in mind that Crude Oil was mostly in backwardation or very small contango for much of the past several years as the below charts demonstrate.

Actually, it is more appropriate to look at the March 2009 and June 2009 spread when comparing the current period to the summer of 2001 (when the 56% annualized contango took place). This is because we want to be about 6 months in advance of the first contract in the spread. In other words, during the summer of 2001 the December 2001 contract was 6 months ahead and as of October 2008 the March 2009 contract is 6 months ahead. When we calculate the contango between March and June 2009, we find that it is roughly 9% annualized, still a far cry from 56%. Here is one more important point. Although the timing is more accurate when using the March/June futures, the results are not adjusted for seasonality and therefore we need to be careful not to use such data in isolation to make our conclusions.

NOTE: Click the charts to enlarge.